Questions Loom Regarding the Response to the Global Slow DownOctober 30, 2014
We have been more pessimistic on world growth than the consensus for the better part of 2014, largely as a result of our very weak readings on China. Our fundamental view sees China as the locomotive of global growth in its role as the newest low cost factory floor. Weakness in China was certain to hinder the limping recoveries in Europe and Japan – the world’s old factory floors – as they struggled to regain market share against a cheaper competitor, with deep pockets to provide customers vendor finance. When there is a slowdown on the factory floor, it shows up in the suburbs, not as rising unemployment, but as financial volatility and falling interest rates. The capitulation in global currency, financial and commodities markets in recent weeks is confirmation that the global economy is suffering a correction. Not a 1982 episode and not close to Lehman, but a cyclical adjustment like in the late 1990s or after Y2K. One reason for the mildness of the downturn is the simple fact that there was never much of a recovery in the US, Europe or Japan – and it’s hard to break a leg falling out of a first story window.
Now the question is how quickly and how significantly will the declines in interest rates and commodities prices stimulate growth. Will there be fiscal stimulus from government authorities to aid and direct the invisible hand – or will growth be met with government austerity as it tries to rebuild its financial stability and credibility? Following our fundamental model, one should look for growth first in the suburbs as the shakeout in financial markets is absorbed and adapted to far faster than we will see adjustments on the factory floor. Fixed income markets have been a far better barometer of the slowdown than equity markets – particularly in how long term rates did not rise as QE was reduced in the US. Now, US rates have broken to a lower trading range sitting at 2.27 for the ten year note Friday. We will watch their movements much more closely than equities as a harbinger of a strengthening global economy in 2015.
In our view, most of the heavy lifting to generate a sustainable recovery will come from reform rather than stimulus. Stimulus is basically an exercise in lowering taxes or increasing spending levels to spark a renewal of activity along a well-worn path. Reform is admitting that previous tax and spending strategies were flawed, and therefore new goals must be set. Stimulus works quickly as confidence grows that the source of the correction is in the rear view window and one can go back to doing what was profitable before – with a little help from the government. Reform is slower, as those that had benefited from the old rules will always fight to preserve even a bad status quo.
In Europe, where stimulus and reform are much needed, the confederation of sovereigns making up the Euro Zone and EU are a significant impediment to reform. Very deep pain has brought about some localized changes in Ireland, Greece and Spain. However, continent wide reforms still seem very far away. Recently, Angela Merkel has acquiesced that Europe needs more investment. This suggests that Germany could back increased budget deficits if they included reforms that reduced spending on transfers and increased outlays for infrastructure. This sounds good, but it is only the formerly strong northern European economies that need investment. The periphery is floating in excess capacity, and needs changes in labor laws, regulatory structure, red tape and lower barriers to entry to compete with other low cost producers. Still, baby steps may help part of Europe to recover, albeit slowly, and support enough growth that tougher reforms will be acceptable where they are most needed.
The preceding is an abridged version of a commentary for McVean Trading and Investments, LLC and has been reposted here with permission of the author.
The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.